Anne Gron, Management & Strategy
risk of terror has challenged the insurance industry and government
to reassess liability, says Professor Anne Gron
attacks of Sept. 11, 2001, jarred many sectors, but perhaps
none more so than the insurance industry.
Faced with $40
billion or more in claims, insurers reacted swiftly to the
increased uncertainty and reduced capital within the industry.
They canceled airlines’ war-and-terrorism coverage and
began to exclude acts of terrorism from commercial policies
up for renewal.
have put airlines and property owners at odds with creditors
and regulators, creating additional uncertainty in an already
swooning economy. Soon after Sept. 11, the Bush administration
arranged for airline coverage through the Federal Aviation
Administration. This coverage is required by most airports,
and limits the liability of the insurers.
to relieve the problems for other sectors did not occur until
November 2002, when Congress passed the Terrorism Risk Insurance
Act. The law provides a three-year “backstop,”
during which the government will pay up to 90 percent of up
to $100 billion in damages from a large-scale terrorist attack.
After that, coverage reverts to the insurance industry.
buyers breathed a sigh of relief at these developments. But
Anne Gron, a Kellogg School professor of management and strategy,
argues that the government’s move may cause more harm
In a recent article
in Regulation magazine, Gron and co-researcher Alan
O. Sykes of the University of Chicago Law School, argue the
insurance industry was largely capable of recovering on its
own — just as it has from other crises. However, as
with other large loss events such as natural catastrophes,
capacity to cover the largest events may not return. Gron
and Sykes argue that past experience with government insurance
programs weighs against long-term intervention to supply insurance
for these events.
They contend that
insurance crises are part of a larger pattern of pricing and
availability in insurance markets, and not a cause for the
government to get into the insurance business.
Gron, who has
studied the industry for 15 years, says the insurance industry
reacted similarly after Hurricane Andrew in 1992, the Northridge
earthquake in 1994 and the boom in liability lawsuits in the
1980s. All caused large unanticipated losses for insurers.
marked by increasing prices, reduced limits, and, sometimes,
the exit of insurers from markets, followed each of these
These changes reflect
the significant loss of capital and the continuing exposure
of insurers to these risks through existing policies. High
prices reflect both higher expected losses and temporary capacity
shortages for these risks, Gron notes. Higher returns to scarce
capital help increase insurance capacity directly and attract
new capital to the industry.
As capital increases
and insurers’ inventory of exposures fall, prices decline
and availability increases. In a typical cycle, prices continue
to fall and a soft market ensues with relatively low insurer
profits. The soft market persists until another large, unanticipated
loss reduces capacity enough to trigger another crisis.
While crises are
part of the adjustment to capital shortages, they cause real
problems for policyholders. Faced with rapidly increasing
premiums, policyholders must decide whether to pay higher
costs or bear the risks themselves. During the 1980s liability
crisis, a few manufacturers chose to withdraw products instead.
Owners of commercial
real estate are particularly affected by the current lack
of terrorism insurance. In some cases, lenders have required
owners to purchase expensive coverage. In other cases, where
insurance is unavailable, lenders and owners bear the risk.
Still, Gron and
Sykes assert that conditions are likely to improve with time,
just as they have after past insurance crises.
The greater danger,
they say, is that the government’s involvement could
undermine the insurance industry as a whole through inexpensive
but poorly managed coverage.